One topic that has been getting increasing attention in 2021 is inflation. With a significant supply of new money in the market, there are concerns about a burst of inflation as economies reopen and pent-up demand comes back online. The high inflation rates of the 1970s and 1980s are a distant memory and for many of us, the world has experienced an extended period of disinflation in the ensuing decades. In Canada and the US, we have become accustomed to inflation near (or below) the 2% target. If inflation re-emerges, it can have significant negatives effects and wealth and wages and monetary policy. Inflation rates of 3% vs. 2% means annual living costs double a full decade earlier (in 24 years, compared with 34 years). Inflation can also be harmful to fixed income returns and destroy purchasing power.
According to a recent survey conducted by CIBC, 60% of Canadians listed “inflation and the rising costs of goods” as their greatest financial concern over the course of the next year1. With a shift in spending, the “adjusted price index” in Canada was up 1.4% in November as compared with the previous year. This was higher than expected with upward pressure from rent (1.9%), food (1.9%) and household items (0.6%). The US saw similar results with core inflation up 1.6% on a year over year basis in November. In both countries, the figure was higher than expected given current economic conditions.
According to recent surveys, consumer confidence in Canada is also back to its highest levels since before the pandemic2. With various government support programs in place, surging home prices and investment portfolios, many consumers have been mostly sheltered from the economic fallout thus far. We could see a rush in consumer spending once restrictions lift (and a burst of inflation).
On a macro level, employment is a key inflation factor. Experts generally agree that the growth in globalization contributed to the disinflation process over the past few decades2. Advances in technology and transportation systems contributed to falling costs, which brought the world’s markets and cultures closer together. Globalization has supplied cheaper labour into the world market, which has kept wage pressure and inflation low. In the future, aging demographics and a movement towards greater nationalization could reduce the global supply of labour and lead to increased wage pressure.
The Other Side
The counter-argument to the reduced supply of cheap labour is that, regardless of aging demographics, is the massive re-structuring of the economy with automation of many jobs, which may keep wage pressure and inflation low. Only a very tight labor market would lead to a sustainable inflation. The impact of wage pressure will be a key indicator to watch in the coming years.
While goods activity recovered to 2019 levels by the end of 2020 in the US, services have not recovered at the same pace. Service providers are reacting to lower demand with limited prices increases or even price decreases. For example, tuition prices in the US have remained flat or decreased3.
Further, according to the US Congressional Budget Office (“CBO”), there will be a deflationary output gap (the difference between the actual and potential output of the economy) through 2030. They forecast that the US economy is going to recover at a very slow rate, with a large output gap and massive debt. The CBO forecast is for low inflation for 2020 to 20304.
This all serves as the backdrop for Janet Yellen (former Federal Reserve Chair) as she becomes Treasury Secretary in the Biden administration. Ms. Yellen is intent on massive stimulus spending and believes that fiscal stimulus plans over the past decade were hampered by antiquated fears of debt and inflation. She has argued in the past that inflation could push above the 2% target, but it is not a great concern, as expectations remain anchored.
The Bank of Canada remains committed to low, stable and predictable inflation. They have pledged to keep interest rates near zero until inflation is sustainably at its 2% target.
Inflation is complex. No single variable determines the future direction and in early 2021, experts continue to fiercely debate the topic. While we may see some inflation above 2%, depending on the pace of the economic recovery, the likelihood of it becoming a macroeconomic issue appear minimal. If inflation rises, central banks are likely to respond with interest rate increases. However, both the Federal Reserve5 and the Bank of Canada6 have indicated a shift to “average inflation targeting”, suggesting they might be willing to allow CPI to temporarily overshoot the target range in the short run, and factoring in prior periods of lower inflation before initiating a monetary policy response. It will be critical for investors to continue to monitor inflation and the actions of central banks in the event of inflation above current targets.